Estate tax elimination could cost heirs

Some advocates of a permanent estate tax repeal might want to consider this warning: Be careful what you wish for.

As is often the case in tax-law changes, when some taxpayers win, others lose. That will be the case in 2010 when, under current law, the estate tax disappears for that year only. Ironically, that same year some heirs will find they owe more in taxes than they would if the tax had remained in place.

"It's a tricky area," says Stephen Trenholm, a CPA and tax manager at Rucci, Bardaro & Barrett in Boston. For some taxpayers, he says, the 2010 change is not tax relief, but "actually a tax increase in disguise."

How can a tax that no longer exists produce bigger tax bills? Because an accompanying change to the valuation system of inherited assets, known as stepped-up basis, goes into effect when the estate tax disappears.

Current law provides a basis tax break for inherited property. Heirs can "step up" the basis of any property they receive to its fair market value on the day that the original owner died.

But in 2010, heirs must assume, or carry over, the departed's basis in the property. This, of course, has tax ramifications. Since some property will have greatly appreciated over the years, lawmakers decided to give heirs a bit of basis consideration: $1.3 million of inherited property receives a step-up in basis, with surviving spouses getting an additional $3 million, bringing the basis total for a widow or widower to $4.3 million.

While that seems substantial, some individuals, particularly nonspousal heirs, will find the step-up change will create capital gains issues they didn't have to deal with while the estate tax was collected.

And if the estate tax is permanently repealed, the basis problem will live on.

Tax cost of selling inherited assets

Year of death

Amount of property exempt from the estate tax

Basis of inherited property used
to calculate capital gains tax

2002 and 2003

$1 million

Full step-up in basis

2004 and 2005

$1.5 million

Full step-up in basis

2006, 2007, 2008

$2 million

Full step-up in basis

2009

$3.5 million

Full step-up in basis

2010

Tax repealed

Carry-over basis, with additional step-up basis of up to $1.3 million for nonspousal heirs; property left to husband or wife allowed additional $3 million step-up (total basis of $4.3 million).

2011

$1 million

Full step-up in basis

Uneven estate tax implications

The new estate-tax repeal and new basis rules won't affect every estate transferred in 2010. But one congressional study estimates that more than 71,000 estates will face at least increased tax-filing and compliance issues because of the change in law, with many of those individuals also actually seeing larger bills than they would under current law.

The number of estates hurt by the change, according to the report prepared by the Democratic staff of the House Ways and Means Committee, is nine times greater than the number of heirs who will benefit from repeal.

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Many of the heirs who will be hit the hardest when the tax disappears in 2010 are likely to be children who lose their lone surviving parent that year and inherit a substantial amount of property.

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